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Traders' Paradise, But Investors Beware


A true bottom needs more work to the downside.


Tired of lying in the sunshine staying home to watch the rain.
You are young and life is long and there is time to kill today.
And then one day you find ten years have got behind you.
No one told you when to run, you missed the starting gun.

...Every year is getting shorter never seem to find the time.
Plans that either come to naught or half a page of scribbled lines
Hanging on in quiet desperation is the English way
The time is gone, the song is over, thought I'd something more to say.

-- Time (Pink Floyd: Dark Side of the Moon)Minyanville's Why Wall Street Will Never Be the Same

How Did We Get into This Mess?

The question I get asked the most lately is "How on Earth did we get into this mess in the first place?" The answer, to me, plain and simple is greed.

I have stated numerous times that markets world-wide, throughout centuries are dominated by individuals that cannot seem to shake the two simplest of emotions - fear and greed. Markets tend to overshoot in both directions as investors experience fear and greed and it is also why I live by the mantra of "Buy from the fearful and sell to the greedy."

In my lifetime, I can trace the evolution of this greed back to a fateful day on May 1, 1975, otherwise known as May Day. Until that day, stock brokers charged a fixed commission on all transactions: There was no negotiation. In order to promote competition, the SEC ended the fixed schedule commissions which had been in place since the signing of the Buttonwood Agreement in 1792, the origins of the New York Stock Exchange. It is believed that over the next few weeks, commission rates dropped in half.

This was a wonderful event for investors, but a bad day for Wall Street as one of their chief sources of revenue had now started down the road of deflation.

When I began my career as a retail stock broker in 1981, commission rates were still rather high and with interest rates in the mid to high teens: even bond commissions were very high. In fact, the very first bond trade of my career was a sale of $25,000 Sayreville, New Jersey School District municipal bonds, and I was paid a $750 commission (3%). As my career transitioned to institutional sales and trading, markets became more transparent and commission rates plummeted even further.

I recall my last transaction on the "sell side" in 1997 of $25 million of US Treasury Notes for a commission of $250. Talk about deflation. You can imagine that there is not much incentive to live in a world where you trade $25 million of securities, assume the inherent risks of a trade failing or a mistake being made, and only be paid $250 for that risk. This was no longer a wonderful way to spend my day.

Brokerage firms saw this trend developing and began transitioning the traditional stock broker into "financial advisors." Financial advisors would typically advise their clients to diversify their portfolios into various styles utilizing a group of pre-screened investment managers in "wrap accounts." So rather than charge commissions on individual securities, portfolios were concocted to diversify their client's portfolios and still be able to charge fees as high as 3% per year.

As an aside, a couple of the wrap program trading desks were my clients while I was an institutional salesman and to be frank, I was never that impressed with what I saw being done for clients, which led me to becoming a Registered Investment Advisor in 1997. To me, the wrap programs looked an awful lot like a bunch of "mutual funds in drag" except with a higher cost structure.

In addition, there were closed end funds which are just publicly traded mutual funds that raise a fixed amount of capital through an IPO whose shares then trade as a stock on a listed exchange. But closed end funds carry commissions and fees that equate to as much as 7% percent of the initial Net Asset Value, which means that the investor paying the IPO price was left with about 93% of their money at work on Day 1.

On top of the 7% in fees, the funds were often leveraged by 50% in order to enhance the yield via sales of Auction Rate Preferred Stock (ARS), the very same vehicle that stranded so many investors earlier this year and that we commented on back in February and that so many brokerage firms have settled lawsuits on lately for vast amounts of money.

In June of last year, I highlighted the structure of closed end funds and the dangers that lurked. Now that these dangers have exposed themselves and the prices have gone through a massive correction, we are now finding many opportunities as my firm begins to buy a few select closed end funds that trade at as much as 40 percent discounts to NAV. We may be early, but buying distressed assets at huge yields at huge discounts to NAV is my cup of tea.

So I suppose one might say that I am slowly becoming more bullish in very specific areas and this is a matter or price, and because we have the cash when others sell more out of fear rather than due to a rational investment decision.

In summary, we can trace the lineage of this greed back much further than sub-prime in our lifetime, and even though it wasn't the beginning of this deadly sin known as greed, the brokerage industry helped get us to the point we find ourselves in now. The traditional revenue streams dried up and yields dropped far enough to entice investors, both individuals and institutions to stretch for yield, ignore prudence, and succumb to ever greater amounts of greed.

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No positions in stocks mentioned.

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